Chart of the Day - 10 year German bund versus 10 year Swedish government bond

"Two roads diverged in a wood and I - I took the one less traveled by, and that has made all the difference." - Robert Frost, American poet.

One of the indicator we have been following in various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is breaking again this time with Swedish yields rising. Back in November 2011 in our credit conversation "The song of Roland", this relation looked like it was breaking due to a German "failed" auction which saw German yields rising above Swedish 10 year government yields. From March 2011 and during most part of 2012, German Bund yields have been moving in lockstep with 10 year Swedish government yields - source Bloomberg:

Although it might be a little bit premature to confirm a clear break in this relationship, it nevertheless warrants close monitoring.

While the Swedish Krona is projected to extend gains in 2013 against the euro for a fifth year in a row (up 4% in 2012), Sweden looks most likely to avoid the euro area's recession woes this year. As reported by Niklas Magnusson from Bloomberg on the 3rd of January: "The country’s central bank, which has lowered rates four times since December 2011 to support growth, has signaled it’s now done with easing policy, which may weigh on a three-year rally in Swedish bonds. “The strong performance of the krona reflects a correction from very undervalued levels following the financial crisis of 2008, but also the relative strength of the Swedish economy and its healthy public and external balances," Kasper Kirkegaard, senior foreign-exchange strategist at Danske Bank A/S in Copenhagen, said last month in an e-mailed reply to questions."

Sweden is one of the 7 only remaining nations boasting a AAA rating with stable outlook along with Australia, Canada, Denmark, Norway, Singapore and Switzerland with a debt to GDP level at 38%.

Although the Swedish rate futures market as indicated by the same Bloomberg article is pricing a 25 bps rate cut in the June contract, given Riksbank cut on the 18th of December its benchmark rate by 25 bps to 1%, traders could be poised to some disappointment should the Swedish Central Bank decides to hold the line in 2013.

Stay tuned!

Markets update - Credit - Goodwill Hunting Redux

"Errors of opinion may be tolerated where reason is left free to combat it."
Thomas Jefferson

Dwindling liquidity has been leading to significant market volatility, in most asset classes. Credit hasn't been spared and while CDS single names and indices are still experiencing important intraday spread movements, Cash bonds in the European markets are not spared either. Thursday and Friday were very interesting, namely because we saw an important acceleration of bond tenders in the financial space (triggered by the Santander bond tender we mentioned in our "Mind the Gap" on the 15th), something we have been expecting to happen from our many previous conversations("Subordinated debt - Love me tender", "Crash Test for Dummies"). In fact in a more recent conversation ("Complacency") we argued:

"Something has gotta give" - subordinated bondholders or shareholders, or both.

Well, it looks like subordinated bondholders are the first in line, and are going to give some back, to help European banks shore up their Core Tier 1 capital as they rebuild/shrink their balance sheet in order to meet the June 2012 European Banking Association threshold of a core Tier 1 of 9%.

In today's long credit conversation, as we go through the latest price action and bond tenders, we will revisit Goodwill impairment, which is definitely back on the agenda, a subject which we already approached in December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet").

But first it is time for a market overview:

The Credit Indices Itraxx overview - Source Bloomberg:

So, three weeks after a supposedly historic agreement on the 26th of October,  we are still near records levels CDS indices wise (Financial indices, and SOVx - European CDS sovereign risk gauge). Itraxx Crossover 5 year CDS index (High Yield gauge) is at around 760 bps, while Investment Grade Europe represented by Itraxx Europe Main 5 year CDS index is around 188 bps.

Itraxx credit indices for Financial Senior 5 year CDS and Financial Subordinate 5 year CDS, remain stubbornly high (300 bps and 538 bps respectively, close to September records level) - source Bloomberg:

Some respite in the Sovereign European CDS Space - source CMA:


In relation to the bond picture, contagion has been spreading to core Europe last week with some respite as well for France and Austria, as well as a pause in the flight to quality with German 10 year yield increasing, but for how long?- source Bloomberg:

In relation to our CPDO/EFSF relationship with French 10 year Government bond and German 10 year bund yields, while French OAT yields have receded, EFSF bonds yields are still rising towards 4%, currently at 3.87% - source Bloomberg:

Another indicator worth tracking is the relationship between 10 year Swedish Government yields and German 10 year Government yields, which, so far have been moving in lockstep, but recently spread between both are moving towards their highest level of 25 bps (contagion to Germany? Not yet) - source Bloomberg:

As far as the liquidity picture is concern, it is clearly deteriorating. The new reserve period for deposits at the ECB which started on the 9th of November will last this time around 35 days:

In relation to the liquidity update, please find an additional point made by Goldman Sachs Sales/Trading teams on EUR FRA/OIS Basis:

"FRA/OIS Basis shows the difference between the overnight and the 3 month interbank borrowing rate and shows the confidence of banks to lend to each other. Current levels show that the confidence is very low as the premium to borrow long term is very high despite recent unlimited LTRO (long term refinancing operation) by the ECB."

In our last conversation on the 15th, we discussed the latest bond tender by Santander in Europe, which in fact triggered a flurry of bond tenders in the market according to Bloomberg article by Esteban Duarte on the 18th of November:

"Societe Generale SA and Banco Santander SA are among banks offering to buy back or exchange part of about $30 billion of junior debt issuance to boost capital and raise money as borrowing costs rise.
The bond tenders that started in Europe this week allow the banks to repurchase subordinated notes at a discount, booking a capital gain, or swap the securities to raise senior debt. Others pursuing the strategy include BNP Paribas SA, France’s biggest bank, and Northern Rock Asset Management Plc, the so- called bad bank spun off from the lender being purchased by Richard Branson’s Virgin Money Holdings U.K."

And the article to detail the flurry of bonds tenders we have been expecting for a while:

"SocGen offered to repurchase as much as 900 million euros of a total $8.2 billion of Tier 1 notes today, at prices starting at 56 percent of face value. Banco Santander, the biggest Spanish lender, asked holders of 6.8 billion euros of subordinated bonds to swap their securities for new senior notes on Nov. 15.
BNP Paribas, France’s largest bank, offered to exchange or repurchase part of about $10 billion of subordinated bond issuance yesterday for as little as 72.5 cents on the dollar, according to a series of statements. SNS Bank BV of the Netherlands announced a tender of Lower Tier 2 notes yesterday, while nationalized U.K. bank Bradford and Bingley Plc is also tendering for debt."

Love me tender?

We already know the liquidity is poor and we discussed previously how issuance under current market conditions is difficult to say the least, it isn't really a surprise to read in the same article:

"“Banks are currently taking advantage of poor liquidity in the market to buy back, or more often exchange, redundant capital instruments on very attractive terms for the issuer,” said Mark Harmer, an analyst at ING Groep NV in Amsterdam.
“It’s definitely a growing trend, especially where traditional access to senior funding channels is limited.”

Given we already know 2012 is going to be a significant year for term issuance for banks ("Mind the Gap..."), you can expect more of the same. First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process.

It was interesting to see as well Deustche Bank increasing the size of a previous 2 year Senior Unsecured FRN (Floating Rate Note) issue by 250 million euros (previous issue size was 1.75 billion Euros, maturity October 2013), at 3month Euribor +75bps.

So yes there is worrying liquidity and funding stress in the European financial system, and according to Bloomberg Liz Capo and Gavin Finch in their article - "Bank Stress Gauges Show Pain Lasting Through ’11: Credit Markets":

"Spanish banks borrowings from the ECB rose 10 percent to 76 billion euros in October, the highest level in more than a year, while Italian firms reliance increased 6 percent to 111.3 billion euros."

And added:

"Italian banks may be forced to increase their reliance on emergency funding from the ECB as their liquidity levels have fallen to levels not seen since January 2009 after the value of the government securities they held tumbled, the central bank wrote in its Financial Stability Report published on Nov. 3.
The ECB announced in October it would reintroduce year-long loans for the regions’ banks as the sovereign debt crisis threatens to lock local money markets. It had previously coordinated with the Federal Reserve to provide euro-area banks with dollars. The central bank offered 12-month loans last month and will off a 13-month loan in December."

According to Radi Khasawneh in the article published on the 18th of November - Italian Banks May Need $8.2 Billion as Government Bonds Slump:

"Italy’s five biggest banks, including Intesa Sanpaolo SpA, may need to raise a combined 6.1 billion euros ($8.2 billion) of additional capital as the Italian government bonds they own deteriorate in value.
Two-year Italian debt, which the banks valued at 97 cents on the euro or better on Sept. 30, trades at about 92.7 cents.
That suggests Intesa, UniCredit SpA, Unione di Banche Italiani
SCPA, Banco Popolare and Monte Dei Paschi di Siena SpA need more capital, today’s Bloomberg Risk newsletter reports."

Given the issue of circularity discussed in our previous post, the more pressure we get on Italian sovereign spreads, the more capital, they will need to raise.

All of the above lead us to revisit a subject we approached already in December 2010 as indicated above, and my good credit friend to comment:

"In term of credit market, following Santander, SNS bank and BNP…Here comes SocGen announcing a tender offer on $1.2 billion of subordinated debt! Hooray! The haircut is 44 %, the tender price is 56%…. I guess the bank will do better next time, if there is a “next time” and will offer tender prices below 50 %.

Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

Goodwill:
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

Indeed, it will be painful. According to Liam Vaughan and Charles Penty, "EU Banks Face $270 Billion Goodwill Hangover for Past Purchases":

"European banks may have to write down some of the $270 billion of goodwill from their purchases in the run up to the financial crisis before they can sell assets, or new stock, to bolster capital.
UniCredit SpA, Italy’s biggest lender, this week opted to take an 8.7 billion-euro ($10 billion) impairment charge following a series of acquisitions at home and in eastern Europe. Other European banks are yet to follow, analysts said.
Credit Agricole SA, Banco Santander SA and Intesa Sanpaolo SA are among European banks with the most goodwill remaining on their balance sheets, according to data compiled by Bloomberg.
“Banks that paid a premium for businesses when the outlook was better will need to reassess the goodwill on their balance sheets,” said Andrew Spooner, an accounting partner at Deloitte LLP in London. “Previous acquisitions which are exposed to peripheral Europe are most vulnerable to impairments.”

We already discussed Austria's exposure to Eastern Europe ("Long hope - Short faith"). Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October.

Liam Vaughan and Charles Penty also commented in their article:

"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report this week, though it didn’t tie the charge to any specific deals among the $60 billion of acquisitions it made from 2005 to 2008."

In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:

"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill."

We also indicated at the time:

"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."

And we concluded back then:

"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."

For more on the subject, Bloomberg Columnist Jonathan Weil had an interesting column relating to Goodwill impairments - "UniCredit Bombshell Shouldn’t Be the Last One".

Time has come once again to become "Goodwill hunters" in relation to bank earnings!

On a final note I leave you with Bloomberg Chart of the Day from the 18th of November relating to debt collection in Spain (the hunt for bad loans...):

"The CHART OF THE DAY shows the proportion of staff in Bankia SA, Banco Popular Espanol SA and the Spanish unit of Banco Bilbao Vizcaya Argentaria SA working in the banks’ collections teams. The second panel shows the amount of bad loans being chased by each of the collection units’ employees. “I’d say it’s more crucial than ever for the Spanish banks to show they’re trying as hard as they can to recover bad loans,” John Raymond, a southern European banking analyst at CreditSights Inc. in London, said in a phone interview.
As the country’s property crash and a stalling economy drive up defaults, the bad-loans ratio of Spanish banks rose to 7.16 percent in September, the highest level since November 1994, according to Bank of Spain data."

"I believe that banking institutions are more dangerous to our liberties than standing armies."
Thomas Jefferson

Stay tuned!

Markets update - Credit - After all tomorrow is another day.

"After all tomorrow is another day", is the last line of the American Civil War novel Gone With The Wind.

Like Scarlett in Gone With the Wind, credit markets, though deeply grieved also seems to hold up, so far, under the strain. And if Gone With the Wind has a theme it is survival:

"If Gone With the Wind has a theme it is that of survival. What makes some people come through catastrophes and others, apparently just as able, strong, and brave, go under? It happens in every upheaval. Some people survive; others don't. What qualities are in those who fight their way through triumphantly that are lacking in those that go under? I only know that survivors used to call that quality 'gumption.' So I wrote about people who had gumption and people who didn't."
Margaret Mitchell, 1936

Here is the market picture for Itraxx 5 year credit indices today following the "shock and awe"(a military doctrine based on the use of overwhelming power) coordinated central banks intervention to ease dollar funding issues for European banks (we already knew about these concerns from previous posts):
Itraxx Crossover 5 year CDS index (High Yield), tighter:

Market closed at around 714 bps, 27 bps tighter.

Itraxx Financial Senior 5 year CDS index:

Cooling off as well.

Itraxx Financial Subordinate 5 year CDS index:

The liquidity picture:

The massive fall in deposits at the ECB is due to the start of a new reserve period on the 14th of September until the 11th of October.
The three-month cross-currency basis swap fell to 80.25 bps from a high of 112.6 bps on the 12th of September, thanks to central banks intervention.

So, who has what Margaret Mitchell calls "gumption" in Europe in the peripheral space?

Portugal 5 year Sovereign CDS versus Ireland 5 year Sovereign CDS:

Ireland clearly is decoupling from Portugal.

Spain 5 year Sovereign CDS versus Italy 5 year Sovereign CDS:

Spain decoupling as well. Spain sold today 3.95 billion euros of bonds maturing in 2019 and 2020 at an average yield of 5.156% compared to 5.2% in February and 5.196% on the secondary market before the auction took place.

The liquidity issues we discussed a month ago in "Macro and Markets update - It's the liquidity stupid...and why it matters again...", is not only a European problem anymore. It is as well a Russian problem:
Bloomberg - Maria Levitov and Denis Maternovsky:
"Russia is struggling to contain a cash squeeze at the nation’s banks after cutting lending rates for the first time in 15 months.
Government bond yields surged to their highest level since February, with the rate on ruble notes due in March 2014 climbing 19 basis points to 7 percent yesterday, as Bank Rossii sought to boost the amount of cash available to lenders by lowering the rate charged on repurchase loans by 25 basis points and lifting the rate earned on deposits by the same amount yesterday. The three-month MosPrime interbank rate hit an almost 19-month high.
Russia is following Brazil and Turkey in cutting borrowing costs as a way of shielding the nation’s economy from a global slowdown as the U.S. falters and the European debt crisis continues. While the refinancing rate was left on hold at 8.25 percent yesterday, the changes to the repurchase and deposit rates should “contain volatility of money market” rates, Bank Rossii said in a statement."

And why liquidity always matter, also from the same Bloomberg article:
“Economic growth must be fueled with liquidity,” Vladimir Osakovsky, chief economist for Russia at Bank of America Merrill Lynch, said by phone from Moscow yesterday. “If this doesn’t happen, growth in money market rates could stifle investment and therefore growth.”

Credit Suisse published today a review of European Banks under the title - European Banks - The lost decade.

Given ongoing liquidity constraints we discussed plaguing European banks in general, and dollar funding in particular, at this point, as the story unfolds/evolves, it is important to try to find out who has "gumption" and who hasn't in the European banking space.

In this lengthy report, Credit Suisse analysts tell us:
"Whilst many observers may see these two events as separate, we see them as part of the same process which ultimately, we believe, may force banks to deleverage and restructure in a much more significant way. Further, as a result of the current crisis, given European banks have only reduced about half of their original sub prime exposures according to our estimates, we could again see losses related to these assets come through the P&L.
Overall, based on our analysis we see that whilst overall losses associated with credit market assets are c.€184bn so far, European banks effectively ‘raised and retained’ a much higher amount to reach a tangible equity position of €811bn last reported. We note that the additional capital has also been part of higher capital requirements mandated under Basel III and is an important indication that European banks are in a better position in terms of capital going into the sovereign crisis. It has also however, been a drag on profitability.
We compare these losses with the potential losses from the current sovereign crisis. On our estimates, assuming an accelerated sovereign shock scenario, we could see a further €213bn of losses i.e. higher than the losses experienced thus far with credit market assets.
This includes:
(i) further losses on sub prime assets (€52bn); (ii) sovereign losses of €125bn and (iii) one year of higher funding costs of €37bn. If we were to include risk weighting for sovereign exposure of €22bn then the total would be €235bn."

 And Credit Suisse to add:
"Estimating the capital shortfall for the sector
Going into this crisis, given higher regulatory capital demands and funding markets requiring larger capital cushions, our base case suggests the sector will still have a €165bn capital deficit at year end 2012E. In the core scenario that we present we estimate the sector would have a total recapitalisation requirement of c.€400bn (Figure 3) compared to the current market cap of €541bn."

Clearly Europe needs a European TARP. Could that be the message that Treasury Secretary Timothy Geithner will convey to European finance ministers in Poland?

We know from my post "Macro and Markets update - It's the liquidity stupid...and why it matters again..." that the lack of disclosure of the LCR (Liquidity Coverage Ratio), which unfortunately is not published by the majority of banks is an issue as Credit Suisse put it in their report: "A more significant market dislocation in terms of bank failure e.g., Lehman in the sub prime crisis,would make a liquidity coverage ratio (LCR) analysis more relevant, as it highlights the vulnerability of funding on a 30-day basis."

Unfortunately as we previously discussed, lessons have not been learn from the 2008 onslaught and the lack of disclosure and transparency for the majority of European banks does not really allow for a proper "gumption" assesment process under very adverse liquidity conditions. But a good point Credit Suisse points out in their report is as follows:
"European banks have effectively ‘raised’ a much higher amount—of €835bn—since 2007 i.e. five times the losses incurred. We note that the additional capital is also part of higher capital requirements mandated under Basel III but it is an important indicator that highlights that European banks are in an improving position in terms of capital going into the sovereign ‘sub-prime’ crisis. This is why tangible equity for the European banks has almost doubled from the level at the start of 2007."

Sweden is also bracing for impact should it happen:
Source Bloomberg - Johan Carlstrom - 14th of September:
“There will be facilities in place to support banks that may have problems,” Reinfeldt said in an interview today in Stockholm.

Sweden has a good first hand experience of financial crisis:
"Sweden, which suffered through a banking crisis in the early 1990s and then again in 2008 and 2009, chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.
The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

On another note, Bloomberg Chart of the day shows that the currency ugly contest is well alive and kicking between the Euro and the Dollar:

And finally, to end up on a less somber note this what I think Ben Bernanke could have said after today's coordinated intervention: I know what you're thinking. "Did the FED fire six shots or only five?" Well, to tell you the truth, in all this excitement I kind of lost track myself. But being this is the FED, the most powerful central bank in the world, and would blow your head clean off, you've got to ask yourself one question: Does the ECB feel lucky? Well, do they, punk?

Stay tuned!

Markets update - Credit - Rates - Equities - The Heat is on...

The Heat is on

The heat is on, on the street
Inside your head, on every beat
And the beat's so loud, deep inside
The presure's high, just to stay alive
'Cause the heat is on

Oh-wo-ho, oh-wo-ho
Caught up in the action I've been looking out for you
Oh-wo-ho, oh-wo-ho
(Tell me can you feel it)
(Tell me can you feel it)
(Tell me can you feel it)
The heat is on, the heat is on, the heat is on
the heat is on Oh it's on the street , the heat is - on

Song by Glenn Frey - Berverly Hills Cop soundtrack.

Another day, another choppy session, indeed the Heat is on and not only on the thermometer reading.

Here are a few market updates:

For a start, that Lehman feeling, courtesy of Bloomberg Chart of the Day:

Negative US yields like in October 2008.

Italy and Spain 10 year bonds still widening:
Italy, 10 year yields surging to new record:

and Spain as well:

One of the reason behind the recent widening can be find in Bloomberg's article published today.
Italy, Spain Stuck in No-Go Debt Zone for Merrill, DWS Funds: Euro Credit

"Merrill Lynch Global Wealth Management, unconvinced that the second Greek bailout has stemmed the debt crisis, won’t put any of its $1.5 trillion of assets into Italian or Spanish bonds."

"Merrill isn’t alone: Frankfurt-based DWS Investment, which oversees $390 billion for clients, and Legal & General Investment Management say they are “underweight” Spanish debt."

Italy is Europe's biggest bond market with 1.8 trillion euros worth of borrowings. Debt to GDP stands at 120%, trailing Greece at 158%, while Spain is still at a very manageable level of 68.1%.
Last Friday Moody's placed Spain's Aa2 rating on review for a cut adding pressure on an already weak market following the US debt ceiling debate and the dismal US GDP figures for the second quarter.
In the CDS space for peripherals:
Spain's 5 year CDS level surging 14 bps to 404 bps and Italy up by 23 bps to 356 according to CDS data provider CMA.
SOVx Western Europe 5 year index up by 14 bps to 291, record was set at 306 bps on the 18th of July.

Hence the flight to quality witnessed so far on 10 year German Government bonds:

and record low on the swiss two years notes:

Here is the 10 year bonds market overview in Europe:

and here is an overview of the two year bond market in Europe:

Seven straight day of loss for the S&P 500, same story for the CAC40 index in Europe, with another week economic data, consumer spending falling 0.2%, slowest growth in personal income since November.

Everyone is focusing on the friday release of the employment figures for the US.

Swiss Franc strengtening more than 2% to a new record of 1.09465 per euro and up 1.4% against the US dollar.

Gold at 1640 USD an ounce, new record.

Big surprise as well in the CDS space with a widening of Sweden 5 year sovereign CDS as well as Swedish Financials:

Swedish Financials 5 year CDS surging today:


According to OECD data, Sweden economy will grow 4.5% this year. Government surplus is 0.3% of GDP, projected to increase to 1.4% in 2012. Gross government debt is at 45% of GDP and falling. The GDP in Sweden expanded 1 percent in the second quarter of 2011 over the previous quarter. Inflation in June was 3.1%.
Sweden 10 Year Government bonds yields.

Sweden's Government Bond Yield for 10 Year Notes declined 13 basis points during the last 12 months.

It is going to be a long week and I am already feeling the battle fatigue, "Risk Off" is still the strategy "du jour" and the Heat is truly on.


To be continued...

The Good, the Bad and the Ugly - Update on some Macro situations

First of all, apologies for not having posted more frequently. I have been quite busy recently on other matters.

In the current market environment, differences between countries are more marked than ever.

While in the Euro area clear divergences are showing, between the German power house and the weak peripheral countries, Greek, Ireland and Portugal sinking further, some countries are clearly doing better than some others.

Not everything is all Doom and Gloom.

It is become more paramount to carefully study in details the full macro pictures in this difficult investment environment, plagued by low yields, rising inflation and high unemployment. Are we moving towards stagflation? Not yet, but signals are getting stronger.

In this post we will review the Good, the Bad and the Ugly, highlighting the differences and reviewing the current market context and significances.

The Good:

We will start by Sweden:

"The Gross Domestic Product (GDP) in Sweden expanded 7.3 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1994 until 2010, Sweden's average annual GDP Growth was 2.68 percent reaching an historical high of 6.90 percent in September of 2010 and a record low of -6.70 percent in March of 2009."
Source - Trading Economics.

Furthermore, Sweden predicts a budget surplus and plans to tax cuts are economy beats Europe according to Bloomberg article from Johan Carlstrom.

"The largest Nordic economy will expand 4.6 percent this year, compared with the 4.8 percent predicted last month, the government said in its spring fiscal policy bill released today in Stockholm. The government raised its forecast for growth in 2012 and 2013 and predicted a widening surplus over the next four years as unemployment falls."

"The Swedish economy grew 5.5 percent in 2010, the most since 1970, as exports recovered from the global financial crisis."

Sweden is doing the right thing:
"Reinfeldt’s four-party government alliance had already revealed it will invest more money in the country’s railway infrastructure and that it wants to ease benefit rules for long- term sick leave. It’s also considering next year cutting income taxes for foreign nationals with “expert knowledge,” dividend taxes for some small businesses and allowing bigger write-offs for investments in research and development."

Applying recipes for expansion:
"The government has cut income taxes by 70 billion kronor ($11.1 billion), or about 2.1 percent of the economy, since coming to power in 2006. It has also reduced corporate and payroll taxes and abolished a levy on wealth."

The results, a booming economy and a fall in unemployment:

A History of Balanced budgets:

Leading to a rising GDP per Capita:

Finance Minister Anders Borg wants Sweden to introduce tougher rules on capital buffers than other countries.
The government is closely monitoring housing to avoid a bubble and already has introduced measures to contain rising household debt such as introducing a loan-to value cap of 85% for mortgage borrowing.

Sweden definitely sits in "The Good" camp, macro wise.

Canada.

I posted before on Canada as a leading example:

Canada, a great example of successful structural reforms and efficient banking regulation

Here is an update on the macro picture for Canada.

GDP Growth for Canada, January 2007 until January 2011:

Canada's budget was either balanced or in surplus, ensuring a reduction of Canada's debt to GDP and enabling them to face the financial turmoil in a much better shape than many other countries.

According to the IMF, Canada’s economy will grow by 2.8 per cent this year, up from an earlier forecast of 2.3 per cent.
The Canadian economy grew 3.1 per cent in 2010.

For the OECD, the forecast is that Canada’s GDP will grow by 5.2 per cent in the first quarter, and 3.8 per cent in the second. In comparison, the OECD has the U.S. economy growing at 3.1 per cent in the first quarter and 3.4 in the second.

http://www.thestar.com/business/markets/article/969530--oecd-bullish-on-canada

"Canada’s economy will grow faster than any other country in the G7 in the first two quarters of 2011."
“That’s full-steam ahead. 5.2 per cent would rank as the second-best quarter of the past 10 years,” said BMO deputy chief economist Doug Porter of the OECD’s Canadian outlook.

Unemployment is falling thanks to solid growth prospects:

Canada is clearly part of "The Good" section of our current macro review.

Another strong member of the group, Germany, the clear power house of Europe.

GDP growth is way above its European peers:

Consequences, unemployment is falling faster than in other EU countries:

What is very interesting is that, 10 years ago, France and Germany were at the same economic levels, both were the leading European power economic houses. Now France is clearly lagging behind. In a future post I endeavour to go into more details about this evolution which we witnessed in the last 10 years and the consequences for France in the not so distant future. Unless some major structural reforms are implemented, like they were in Germany, France will not move in the right direction.

The German discipline:

"The Good, the Bad and the Ugly" in the Eurozone per GDP Growth in 2010:

"The Good, the Bad and the Ugly" in the Eurozone per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Scandinavia per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Latin America per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Major Economies per Government Budget Country Ranking in 2010:

Governmnent Yields 10 Year Notes - Source Trading Economics:

The Bad:

United Kingdom struggling to surge from the ashes of the financial crisis:

Inflation lower this month to 4% thanks to price war between major UK retailers:

I posted extensively on the effect QE in the UK would have on inflation on this blog. Previously, I commented that the Bank of England is facing a difficult situation, with the rise of inflation and its mandate of keeping it around 2%. At some point the Bank of England will have to raise rates, but, given the fact two thirds of UK mortgages are depending on short term rates and UK households are already massively leveraged (debt to income at a record level in the G7 countries club), the risk of a double-dip is massive and Mervyn King is fully aware of the difficulties that lie ahead. Mervyn King is trying to delay as much as possible the inevitable rise in interest rates and the March inflation figure at 4% clearly gave him some small room to breath.

UK budget deeply stretched:

UK unemployment levels not falling fast enough at the moment:

UK unemployment rate for the three months to February 2011 was 7.8 per cent of the economically active population, down 0.1 on the quarter. The total number of unemployed people fell by 17,000 over the quarter to reach 2.48 millions.

France is yet again, delivering below par performance which is clearly not helping its already strained budget.

A slow GDP growth below potential for France:

A sticky unemployment level due lack of structural reforms and flexibility in the labor market:

A decaying trade balance, January 2000 - April 2011:

As a comparison, France's closest and biggest trading partner, Germany has seen its trade balance soar, leading to a faster and more solid GDP growth.

Could France lose its coveted AAA rating? One thing for sure, the decoupling of the French and German economy has increased dramatically in the last ten years. I will post more on the subject in a future post.

Another member of "The Bad" group in the Eurozone is Italy.

"The Gross Domestic Product (GDP) in Italy expanded 1.5 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1982 until 2010, Italy's average annual GDP Growth was 1.45 percent reaching an historical high of 4.70 percent in December of 1988 and a record low of -6.50 percent in March of 2009. This page includes: Italy GDP Annual Growth Rate chart, historical data and news."

Italy GDP growth from January 2000 to April 2011:

While benefiting from a GDP boost following the introduction of the Euro after 1999, since then, Italy's GDP growth has been overall muted.

As The Economist posted in early April, Italy can be seen as the Achilles heel of Europe.

"ITALY’S public debt is the sleeping dog of the euro zone’s crisis. So far the markets have mostly let it lie. Although in 2010 it rose by three points, to 119% of GDP, Silvio Berlusconi’s finance minister, Giulio Tremonti, held the budget deficit to an impressive 4.6%, well below his target of 5%."

The article goes on:

"In fact the euro crisis has again laid bare the structural weaknesses in Italy’s economy. When euro-zone GDP falls, Italy’s falls by more; when it rises, Italy’s rises by less (see chart). The country has too few big firms. It is not generating jobs for the young: more than a fifth of the country’s 15- to 29-year-olds neither work nor study. Too few women have jobs (in the euro zone only Malta has a lower female-participation rate). The south remains a huge drag: in broad terms, GDP in the north may grow by as much as 3% a year, but in the south it shrinks by 2%, pulling the average down. Youth unemployment in parts of the south is 40%. And, as the Bank of Italy’s governor, Mario Draghi, has noted, Italian entrepreneurs have to cope with an unusually high level of organised crime. Police operations show that the ’Ndrangheta from Calabria has burrowed deep into the economic fabric of the north."

For the excellent The Economist interactive guide on the Eurozone spreading infection please use the below link:

Europe's economies - Spreading infection

Unemployment for Italy is still too high: January 2000 - April 2011.

But Italy's public finances were held tight thanks to its finance minister.
Italy Budget Deficit from January 2000 until April 2011:

Much tighter than France for instance.

The issue for Italy is that to meet the European rules on public debt, Italy will need annual economic growth of about 2 percent and a balanced budget. I do not see it happening in the near future.

ECB’s Draghi Says Italy Needs GDP Growth Near 2% for Debt Rule - Bloomberg

"The European Union last month reached an agreement on tougher economic oversight rules for member countries, including fines for governments that don’t cut overall debt fast enough. The accord came after Italy, with debt of 118.9 percent of gross domestic product last year, pushed for a broader definition of government borrowing that may offer a better chance of avoiding future sanctions for violators of the debt rules.

While countries with debt over 60 percent of GDP will be required to make annual cuts equal to 1/20th of the excess, progress will be judged against a range of “relevant factors,” the ministers agreed. Italy has pushed for private debt levels, which are low in Italy compared with the EU average, to be included in the gauge."

Analysis: Marchionne offers reform model to stagnant Italy - Reuters

"There is no doubt Italy is in dire need of reform."

According to this article from Reuters by Gavin Jones and Lisa Jucca

"Its economic growth consistently lags its euro zone partners and, according to International Monetary Fund data, it was the world's fourth most sluggish economy between 2000 and 2010, ahead of Zimbabwe, Eritrea and Haiti. Real disposable income has been stagnant since 1990 and the average hourly wage, adjusted for the cost of living, is 30-40 percent below that of its three main European peers, Germany, France and Britain. It is the only euro zone country where per capita output is lower now than it was in 2000.

Of course there are many reasons for this state of affairs, but analysts agree that one factor is the rigid and centralised system of industrial relations and an inability to increase productivity in line with its competitors."

But it is not too late for reforms. Germany remain's Italy’s largest trading partner. Germany is purchasing 12.7 per cent of Italian exports.

What is currently plaguing Italy's economy remain its ongoing North-South divide. Italy is a two zones economy and it is hindering its growth dramatically:

It is not too late for France either.

Both Italy and France, need to become probably more like Germany. In order to do so, they have to go through much needed structural reforms: Productivity and competitiveness were key to Germany's recent success.

The Ugly - Peripheral Europe:

Ireland has been the subject of quite a few posts on this blog.

Ireland debt status is now closer to junk following another round of downgrades from the rating agencies:
Moody's downgraded Ireland to Baa3 status with a negative outlook.

The Irish economy contracted for the third year running in 2010. GDP growth of 0.9% and 2.2% is forecast for 2011 and 2012.

As I posted previously, the Irish financial sector sunk the country.
Allied Irish Banks latest financial results is a good indication on how the country's public finances were deeply put into the red. AIB used to be Ireland's largest lender. AIB revealed additional losses recently: 10 billion Euros in 2010 from 2.3 billion Euros in losses a year earlier.

Now AIB, which is almost totally owned by the Irish government.

So far AIB has received 7.2 billion Euros in government aid to date and we know now it needs an additional 13.3 billion Euros in capital, following the latest Irish banks Stress Tests. On its own, AIB's capital injections so far represents an incredible 12.5% of GDP. And this is just for AIB, I am not including, Anglo Irish or Bank of Ireland.

There is only one explaination for the high losses in the Irish financial sector: High concentration of risk in property lending. Anglo Irish's loan book was on 10 promoters only as indicated previously.

Since Ireland embarked on its fiscal austerity programme two years ago, the Irish economy has contracted by at least 11%, and, 16% in three years in total. Consumer spending is down 14 percent since 2008.

"Commercial property prices have plunged 60 percent since peaking in 2007, while rents have fallen an average 50 percent, according to real-estate agent CB Richard Ellis Group Inc. (CBG)"

Source Bloomberg: Irish Retailers Fight Investors Over Rents After Economy Sinks

For the IMF, Irish growth will be "Ugly" in 2011, a miserable 0.5% according to there latest forecast.

In comparison:

"Growth for the Euro Area is estimated to be 1.6%. In advanced economies worldwide, growth is estimated at 2.5%, with developing world growth put at 6.5%."

The employment in Ireland is as well, a truly "ugly" picture:

Ireland Unemployment: January 2000 - April 2011

The blame for financial crisis is not all our own
We need to draw attention to punitive stance on financing of bank resolution, writes Colm McCarthy

"Holders of Irish bank bonds should take losses instead of the Irish Government footing the bill for their bailout," European Central Bank governing council member Axel Weber said.

Mr Weber added:
"To save a country's banking system, it is not necessary to write a blank cheque for the total balance sheet of the banking system."

"'In Ireland, the question is whether the banking sector has to be saved as a whole,' he added. 'Would it not be a better route to isolate deposits, to minimise losses to Irish taxpayers and to find a complete solution . . . with private sector participation instead of buying them out.'"

"Mr Weber echoes the consistent editorial position of the Financial Times, the Wall Street Journal and the Economist magazine among others."

This is the difficult dilemna, Ireland is facing, haircuts or more austerity for its taxpayers.

As for Portugal, last time it received an IMF package in 1983, the result was higher productivity and exports. Is it going to be different this time?
The key element for Portugal, as well as Spain to some extent, lies in a major structural reform of its labor market. Portugal needs to become more competitive again. Competitiveness is a key factor of success as highlighted by the German economic situation.

Portugal benefited as Italy in a short boost to its GDP growth after 1999, but since then, its GDP growth has not been stellar to say the least:

Portugal GDP Growth: January 2000 - April 2011

"The Gross Domestic Product (GDP) in Portugal expanded 1.20 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1989 until 2010, Portugal's average annual GDP Growth was 2.16 percent reaching an historical high of 6.50 percent in March of 1995 and a record low of -3.70 percent in March of 2009."
Source Trading Economics.

Austerity is biting even more Portugal's employment levels:
Portugal Unemployment Rate Jan 2000 - April 2011

As a reminder, CDS for financials are deeply correlated to Sovereign CDS levels as of the 7th of April 2011.

In regards to Greece, the writing is on the wall and a restructuring seems to be the most likely outcome:

Greek Government bonds run on the 14th of April 2011:
Price Yield

GGB 4.6 05/20/13 78.4410 17.8539
GGB 5 1/2 08/20/14 68.2760 19.1830
GGB 6.1 08/20/15 67.1960 17.3838
GGB 3.6 07/20/16 58.9710 15.5923
GGB 4.3 07/20/17 59.1350 14.7267
GGB 4.6 07/20/18 59.2450 13.8444
GGB 6 07/19/19 61.2950 14.257
GGB 6 1/4 06/19/20 64.1660 13.1971
GGB 5.3 03/20/26 58.6110 11.0967
GGB 4.6 09/20/40 53.6850 9.2031

Greece Sovereign CDS 5 year spreads reached a record on the 14th of April 2011 to 1164 bps, implying a Cumulated Probability of Default of 60% according to CMA.
CDS 5 year levels for Peripheral countries as of the 14th of April 2011:

Conclusion:
A real recovery in productivity is the only way for a sound economic recovery.

An interesting article as a follow up on European Banks financial woes:

Euro vs. Invasion of the Zombie Banks

By Tyler Cowen in the New-York Times

Are we seeing the application of Gresham's law in current market turmoils and hot money pouring into Emerging Markets? I will discuss on this subject in a future post.

Gresham's law as per wikipedia:
"Gresham's law is an economic principle "which states that when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation."

"It is commonly stated as: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law."

Robert Mundell believes that Gresham's Law could be more accurately rendered, taking care of the reverse, if it were expressed as, "Bad money drives out good if they exchange for the same price."